All About That Credit is a 4-part series about establishing, improving and maintaining good credit. Credit is a complex topic, and while I hope this series will be informative, I welcome questions specific to your particular situation.
Part 2: Installment Accounts
Are you considering a loan to buy a car, or procuring a mortgage to purchase a home? Do you have student loan debt? If you answered yes, then you probably have an installment account. These accounts have a fixed payment for a fixed period of time. You do not have to pay them in full each month, or make interest only payments, as with revolving accounts, such as credit cards and other lines of credit. Installment account payments will be the same every month until the loan is paid in full.
Similar to credit cards, lenders charge an annual percentage rate, known as APR. This is how they make money. The APR is essentially the price of taking the loan – what is costs you, the borrower, to make payments over time and take ownership of an asset.
So, how is the APR determined on your installment account loans?
That is a great question. A number of factors are considered in order to qualify for an installment loan. Let’s take a look at three primary factors lenders review:
- FICO Credit Score: Scores range from 300 to 850 and help lenders determine your credit risk. A higher score may qualify you for a better interest rate from lenders.
- Income: Lenders review your gross income to determine your earning power for repaying the loan. This means your annual salary, or for self-employed persons, your gross profit.
- Debt-to Income Ratio: This metric is calculated by taking all monthly debt payments and dividing them by your gross monthly income (money before taxes and deductions). This number helps lenders measure your ability to make the monthly payments to repay the loan. As an example, home mortgage lenders usually require a debt-to-income ratio of 36% or less.
Together these factors will help lenders understand how much you can responsibly afford to borrow and how likely you can manage the monthly payments.
Being prepared is the best thing you can do when taking on, or refinancing, an installment loan. So as you consider buying a new car, that cute fixer upper, or refinancing your student loan debt, understand how the above factors will impact your particular situation. Regardless of your next move, you’ll at least know where you stand and likely put yourself on a path to a better long-term financial future.
Next up: Part 3 – Your Credit Report
